Compound Interest Definition and Explanation

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Compound interest is a common term you hear when it comes to investing. But, what exactly is compound interest, how does it work, and how can you best take advantage of it? I’m sharing what you need to know in this compound interest explanation.

Compound interest definition

So, what is compound interest? Compound interest is the principle by which the interest you earn on your investment also earns interest. The larger your balance gets by earning interest, the more interest you earn.  

Keep in mind that the fact that compound interest allows you to earn interest on the interest makes it different than simple interest which just allows you to earn interest on the original investment only.

How compound interest works

As mentioned above, what makes compound interest different from simple interest is the fact that you will earn interest on your interest. This means your money can grow at a much faster rate over time.

For example, let’s say you have $100 invested at 5% interest for 5 years. With simple interest, you are only earning interest on the original principal, the $100. This means you will earn $5 per year so by the end of the five-year period you will have a total of $125.

Now, if it’s compound interest, your annual earnings will continue to increase because you aren’t just earning interest on the principle, but on the total amount. So in the first year, you will make that same $5 in interest but, come year two, you will be earning your 5% on $105, not $100, which means you will finish year two with $110.25. By the end of 5 years, you will have $127.63.

As you can see, compound interest has the ability to snowball and continue to grow your money at a much faster pace than simple interest. In other words, invest your money as soon as you can!

How to calculate compound interest

When it comes to figuring out what you can earn in compound interest, the Rule of 72 will give you a good reference. 

The rule of 72 will tell you how many years it takes to double your investment when the interest is compounded. You get this number by dividing the number 72 by the interest rate to get the number of years it will take. So, say your annual interest rate is 5%. 72/5 = 14.4 which means it will take a little over 14 years to double your investment, whatever it may be, if the annual interest rate is 5%.

The rule of 72 is a quick and handy trick to use but if you want a real breakdown, then there are two methods that you can use to calculate compound interest. The first is to use a compound interest calculator which can be found online. Or, if you are half-decent with math, you can run the numbers yourself with this formula:

A = P ( 1 + r / n ) ^nt

A= the value after t periods
P= Principal (amount of your initial investment)
r= annual nominal interest rate (not reflecting the compounding)
n= the number of times that the interest is compounded per year
t= the number of years the money is borrowed for

How to take advantage of compound interest

Clearly, compound interest is ideal and will get you further ahead faster than simple interest. That being said, there are still some strategies to use to take advantage of compound interest and make the most of it.

Invest for the long term

The compounding effect benefits you more the longer you can keep it going. So hold on to those investments to ensure you get the most out of them. Think of compound interest as one of the 9 easy ways to earn passive income. Once you have your money working for you, it’ll just keep growing.

Invest early

The earlier you start, the longer your investments have to grow and continue to make money for you. Think of compound interest like a snowball, the longer you keep it rolling the bigger it will get.

Make regular contributions

If you can swing it, contribute on a monthly or even weekly basis instead of just annually. Remember, you earn money on your interest so the more opportunities you have to earn interest, the more you will earn.

Use a robo advisor

The three above tips are best used in conjunction with a robo advisor. By automating your contributions with a robo advisor, you can let them take care of the investing for you. There’s not much to do once you’re set up so you can take advantage of compound interest. Some of the best robo advisors in Canada include JustWealth, Nest Wealth, Weathsimple and WealthBar (now CI Direct Investing).

When compound interest works against you

Compound interest is fantastic when it means you are making more money. However, when it comes to credit cards, bills, and money owed then compound interest can work against you very quickly.

As you likely already know, credit cards use compound interest. This interest is generally compounded on a monthly basis and since most credit cards are notorious for their high interest rates, your debt can get out of hand pretty quickly. To help avoid this you’ll want to make sure to pay off your credit cards on a monthly basis. If this isn’t always possible, then make sure to choose a credit card with a low interest rate

Final thoughts

In terms of investing, compounding interest is absolutely the best option and if you use some of the tips I’ve shared above, you can make it work in your favour even more. However, keep in mind that compound interest works both ways. While it’s ideal for investments, it’s terrible when you owe money so keep an eye on any debts and bills owing.

About Barry Choi

Barry Choi is a Toronto-based personal finance and travel expert who frequently makes media appearances. His blog Money We Have is one of Canada’s most trusted sources when it comes to money and travel. You can find him on Twitter:@barrychoi

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